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  • Writer's pictureSteve

The Fall of Indexing?

As the stock market continues its recovery I believe I'm beginning to see something I've pondered the possibility of the last few years but have been reticent to share - the idea that the era of "indexing" may be coming to an end.  Recall, indexing is the idea that instead of picking individual companies/stocks to invest in, one should instead just "buy the entire stock market," i.e. an index fund.  Indexing has become increasingly accepted as THE way to invest.  Indeed, it's something I, myself, practice in all client portfolios.  But what is wise today may not be so tomorrow - times change.  Before I get into why I think times may be changing, let's review how we got here.

    While popular today, indexing wasn't always how individuals invested. For a long time, if an investor wished to become involved in the market, he or she could only purchase individual stocks.  You had to build a portfolio position by position.  Then mutual funds entered the fray and an investor could pass on the painstaking job of research, analysis, and purchasing and instead just buy one fund comprised of a couple dozen to a few hundred stocks.  Here, the investor left  the work of choosing the actual investments to a portfolio manager.  Finally, after reams of data appeared saying you could just buy an entire stock index and get a similar or in many cases better rate of return, came indexing.  While I couldn't argue with the data, the idea that less work could be better than more work has always bothered me.  Common sense and our own experience tells us that while yes, in some cases, that may be true, or true for awhile, generally speaking, it's probably not a theme to go through life believing is universally true.  Especially when it comes to something as potentially rewarding as investing can be.  

     Which brings us to today.  With the arrival of Covid-19 there are now broad swaths of the economy that are certainly near-term impaired and perhaps long-term as well.  Businesses such as hotels, restaurants, airlines, travel/tourism, etc. have all had to take on a large amount of debt just to survive.  While these companies may indeed fight on, debt servicing may make it difficult for share price to rise much over the next 5-10 years as profits will go to paying off debt.  With entire sectors acting as a drag on, say, an S&P 500 index fund, it may be difficult for that fund to appreciate much.  Instead, as Mohamed El-Erian noted in an earlier commentary, it may make sense to look for individual companies to invest in that don't face those same challenges.  El-Erian mentioned at the time companies with strong balance sheets such as Microsoft, Amazon and Google.  One has to look no further than the last few months and compare the charts of the tech giants mentioned above with names like Marriott, The Cheesecake Factory, and American Airlines.  The difference is stark, and potentially long-lasting. 

     Ultimately, if this theme plays out, I don't believe we'll see it discussed for years, if not decades (that's one of the reasons it interests me) in the mainstream.  There has been so much time, money, and energy invested in the idea of indexing that it can't simply be reversed in a few months, or even years.  The same data that built the case for indexing will need to be accumulated in favor of a portfolio building approach.  Similarly, switching an investment philosophy is not something I, or anyone, should take lightly.  More time is needed to see if this is what is really happening.  And, even if it is, it's unlikely an entire portfolio should ever completely eliminate all index funds.  In the meantime, I will continue to take an interest in observing this potential phenomenon to see if it continues.  

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